Understanding the Importance of Joint Venture Governing Documents on Fair Market Value

Several important healthcare industry trends are adding to the growing popularity of joint ventures in health care. Some joint venture arrangements, such as those involving inpatient rehabilitation or dialysis service lines, are driven by the hospital’s or health system’s lack of specific domain expertise or a need for capital. Others, such as ambulatory surgery or infusion centers, are important components of physician alignment strategies. And finally, hospitals and health systems are looking for the ability to provide care in the lowest cost setting, and often these ambulatory strategies help to meet that objective.

As hospital leaders explore opportunities for partnership, they should keep certain key considerations in mind when structuring governing documents for these entities. The governance structure can further the strategic purpose for the arrangement, but it also can pose compliance risks and impact the FMV of minority interests. 

Understanding DLOCs and DLOMs

The financial terms of joint venture transactions in health care usually need to be documented as consistent with fair market value. The entity’s governing documents influence the valuation of partial ownership interests (such as joint venture interests) primarily through their impact on the selection of appropriate discounts for lack of control (DLOC) and marketability (DLOM)—at least when adhering to the fair market value standard of value. Thus, for example, the value of a partial interest in a company (i.e., 30 percent) does not necessarily equal 30 percent of the value of the whole company. 

Discounts for lack of control (DLOCs) typically apply when the ownership interest is noncontrolling. That is, an ownership position whereby a shareholder owns less than 50 percent of outstanding shares and has little or no control over decisions. DLOCs should be reflective of the level of control of the interest. Discounts for lack of marketability (DLOMs) also may apply, because interests in privately held companies are not easily converted into cash. DLOMs should be reflective of the owner’s ability to do so.

Which Provisions Matter Most?

Accordingly, the provisions that have the greatest impact on valuation deal specifically with issues of control and marketability. They include the following.

Voting rights and board/management election. The process for electing board members and management is the primary factor that determines the level of control of an ownership interest (and therefore, the DLOC). Many “true” joint ventures require the consent of both parties for any major decisions or elections/appointments, which would justify only a small DLOC, if any, particularly if both parties make significant contributions to the initiative such that the joint venture is more valuable than it would be if it were owned by a single party. On the other hand, a small minority interest with minimal or no voting rights might warrant a sizeable DLOC.

Distribution policies. The distribution policy, which determines the process for returning cash to owners, is perhaps the only provision that has substantial impact on both the DLOC and DLOM. It essentially controls the process for determining what the entity does with the cash it generates. Distributions represent a form of liquidity that improves the marketability characteristics of the interest. Provisions that require the distribution of all available cash flow result in higher valuations for minority/non-controlling interests, all else being equal, than provisions that require approval of a board or manager (i.e., increasing the DLOC/DLOM and reducing the fair market value).

Restrictions on transfer. Many governing documents include provisions that restrict the sale of ownership interests by doing one or more of the following:

• Requiring approval of the board, management, or other members
• Subjecting transfers to a right of first refusal held by either the entity or the other members (or both)
• Restricting ownership to a limited pool of individuals (such as practicing physicians within certain specialties and geographies)

The more stringent these restrictions are, the more impact they have on the marketability of the interest (i.e., increasing the DLOM and reducing the fair market value).

Buy/sell provisions. These provisions outline the financial terms of any future ownership transactions. Although the most common and lowest-risk approach is to set the price of any future transactions at fair market value as determined by a qualified appraiser, many operating agreements rely on a formulaic approach.

For example, a hospital-physician joint-venture surgery center might use 1.0x earnings before interest, tax, depreciation, and amortization (EBITDA) for future physician buy-in and buyout transactions. Although using such a low multiple may fulfill a strategic purpose—for example, by attracting new physician investors and deterring existing ones from leaving—it also poses the risk of being interpreted as inducement to perform surgeries at the center.

One potential alternative that many legal teams find acceptable is the use of a formulaic approach for buyouts, but not buy-ins. The rationale is that the selling physician will no longer perform surgeries once he or she has retired or left the area, reducing the perceived compliance risk when selling. This approach creates a clear deterrent to withdrawal (due to the low buyout figure) and, further, can reduce the fair market value of buy-in transactions because of the buyout formula’s significant impact on marketability (i.e., increasing the DLOM and reducing the fair market value).

Determining the Right Approach

Governing documents can play an important role in furthering the strategic purpose of a joint venture arrangement, but certain terms  can create compliance risks and impact the FMV of minority interests. It’s critical for healthcare organizations to find the right balance when developing their approach. 

Karin Chernoff Kaplan, MBA, CVA, is a director, Veralon, Philadelphia, and a member of HFMA’s Metro Philadelphia Chapter.